Debt to GDP Ratios: Why Not Make the Numerologists Happy?

Monday, 01 April 2013 04:36

Numerology is usually held in low regard in intellectual circles. Unfortunately it is front and center in the debate over national economic policy.

Many economists and political leaders tell the public that we have to keep the DEBT to GDP ratio (capitalized to show reverence) below some magical level. Greg Mankiw professes his adherence to the faith in the NYT on Sunday. The reason that either a specific number or a strict focus on debt to GDP ratios is viewed as silly by people who are not numerologists is that the DEBT to GDP ratio is a completely arbitrary number that tells us almost nothing about the financial health of the government or the country.

First, the debt to GDP ratio is not even telling us anything about the burden of the debt on the government's finances. While the current debt to GDP ratio is relatively high, the ratio of interest payments to GDP is near a post-war low at 1 percent of GDP. (It's roughly 0.5 percent of GDP if we net out the money refunded to the Treasury by the Federal Reserve Board.) By contrast, the interest to GDP ratio was six times as large in the early 90s, at 3.0 percent of GDP.

If we revere debt to GDP ratios, we will have the opportunity to buy back large amounts of long-term debt at steep discounts if interest rates rise later in the decade, as projected by the Congressional Budget Office and others. This exercise would be pointless, since it leaves the interest burden unchanged, but it should make the numerologists who dominate economic policy debates happy. (This debt buyback story is discussed here.)

The other reason why an obsession with government debt is absurd is that it ignores all the ways in which the government may increase national wealth or impose burdens that are not captured by the debt figures. Suppose that the government were to increase debt through a massive public investment program in clean technologies, publicly funded research (with results in the public domain), and free education.

The debt to GDP ratio would surely increase, but (let's imagine success) the country would be far more productive in the future. Suppose we could get wind or solar energy to meet most of our needs at virtually no cost on an ongoing basis. (This is hypothetical, so don't give me an argument here.) Suppose all our prescription drugs and medical supplies were available as low cost generics, saving us more than 2 percent annually ($320 billion a year in today's economy) in health care expenses, and suppose that we had a much more educated and productive workforce with no student loan debt.

If this accurately describes our future in the big public investment scenario, should we be upset if our debt to GDP ratio were 30 percentage points higher? Suppose this actually translated into a higher burden of interest payments to GDP. Imagine that it increased by 2 percentage points of GDP, an amount almost as large as our annual savings on payments for prescription drugs and medical equipment.

Of course economists would have no basis for saying that we are worse off in this high debt to GDP ratio scenario. But the numerologists who control public policy would not like it. So look forward to high unemployment and slow growth in the hope of appeasing the god of DEBT to GDP ratios.

He really kind of argues against himself as he describes (briefly) the fiscal history of the US, which is that debt has always been present to varying degrees and we do not seem to be the worse for it. He does the usual comparing the federal budget to a personal budget-which is just wrong because they are fundamentally different things-economic forces act on them in different ways. But, you could use this analogy in a useful way. To use Dean's example on a person-level you could take on more debt but put that debt towards something that will give you future benefits-education is a common example or if you are out-of-work you may need to use a credit card for essentials, maybe paying just the minimum for a period of time. The former is considered "good" debt-it will increase your future earnings. The latter is not considered good. However that's mainly because the interest rates are so high-which is not the case for the federal situation-but nobody would say a person was "bad" (moralize) a person for doing such a thing if it was a question of survival. Likewise at the federal level we should not be cutting programs that people are surviving on just because the Very Serious People have crazy ideas of what numbers should be. But he completely lost me with this: ". . . when we are lucky enough to enjoy peace and prosperity, the debt-to-G.D.P. ratio shouldn’t just be stable; it should be falling. " I'm assuming he doesn't think we are at war, so he thinks we are in "prosperity" now?

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...written by Lynn,
April 01, 2013 9:38

It seems to me that buying back debt at a discounted value in the future due to an increase in interest rates would be a helpful thing. If you can reduce the future principal due while at the same time keeping your interest payments steady sounds like a very big thing to me. Of course the holders of the debt may not be too happy about that (they don't have to sell if they don't like it), but the taxpayers as a group should be overjoyed to get a break on their debt obligations. The next time interest rates fall taxpayers will see the benefit of lower rates on a smaller debt burden. I would call that a nice gift from the "debt fairy".

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Happy April Fool's Daywritten by Peter K.,
April 01, 2013 11:30

Here's to our favorite fools: from George Will to Bobo Brooks to Eeyore Samuelson to that TV rager Santelli. A ship of fools / confederacy of dunces.

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Superstitious Indeedwritten by DHFabian,
April 01, 2013 12:37

Democrats and the middle class sacrificed the poor to the economy god. It doesn't look like it was enough to appease that god, however.

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Specious numerolgywritten by Charlie,
April 01, 2013 2:17

The debt to GDP argument makes sense primarily within the context of the GOP's current needs, which revolve around never paying back the Social Security trust fund. Really, the whole GOP fiscal strategy dating back to circa 1983 can be explained as a plan to substitute taxes on labor for taxes on capital, and now to avoid paying them back.

The on-budget federal debts incurred during the Reagan and Bush years roughly amount to double the SS surpluses since the 1983 SS reform - so they spent the SS surplus TWICE to insure it could not be paid back.

W/R/T the Fed unwinding its balance sheet in the future -- post 6.5% unemployment -- I have a question:

Why does the Fed have to sell its investments? Why not simply shred them?

Oh, right -- you say all those excess reserves will go pouring out into the economy; inflation, inflation, inflation. Not so fast. Increase the reserve ratio. No more excess reserves.

What's wrong (or right) with my thinking?

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Comparing Stock and Flow?written by Alan,
April 01, 2013 5:21

In my introductory accounting courses, the teachers always emphasized that we should never compare stocks (e.g. balance sheet items), with flows (e.g. income statement items). They are, we were told, qualitatively different -- stocks are fixed as of a particular point in time, while flows are measured over a conventionally-chosen time frame, usually one year. Yet surely debt is a stock and annual GDP is a flow. I see the ratio between the two cited all the time, but I have never seen an explanation of why it is a meaningful number. Can anyone help?

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NGW needs to preface any statement on debt with written by winstongator,
April 01, 2013 6:04

"I helped enable the Bush tax cuts". It's hard to read where he says in normal times the debt/gdp ratio should go down and not think 'wtf were you doing in early 2001 then?' As John McCain said, we have never cut taxes during wartime - so you should be able to separate out the impact of the wars from the tax cuts.

BTW, I agree that we should reduce the debt/GDP ratio precisely because $hit happens that will increase it. Because of that...I was against the Bush tax cuts. Hard to have it both ways.

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...written by Anon,
April 02, 2013 9:23

@Alan I believe I can help you understand. This nonsense about the debt to GDP ratio originated, I think, from the Deficit to GDP ratio that was used by european countries in the Maastricht treaty. This deficit to GDP ratio was invented in 1981 by a french civil servant, Guy Abeille. French President Miterrand needed a simple instrumental rule to control his ministers on the budget front. The ratio was tailored for the occasion, although it doesn't mean anything, and then used by french ministers in interviews, etc. Public opinion progressively got accustomed to hearing about it and accepted that somehow it was an indicator of public finance health. So now politicians are trapped : if the government violates the nonsensicle rule, its opponents will go crying on TV that they are being irresponsible and people will believe it because they have been led to think the argument is a serious one. And the government cannot go on air and say : 'sorry, this ratio doesn't mean anything, we have been lying each time we used it as an argument to support our policy, but please, don't hold that against us and reelect us'. They are trapped : it doesn't matter anymore that it doesn't make economic sense, because the public has been led to think it does. So what makes no economic sense now makes politicial sense.

@Alan - Nothing wrong with your thinking here. Debt to GDP is a prime example of why you don't compare stocks to flows. In fact, the ratio was cooked up out of whole cloth, and the powers that be blessed it because it gave the "right" answer; ie, that government was too large, and spending had to be cut. If the Debt to GDP ratio had given a different answer, it never would have been heard from again. Pure confirmation bias. All hat, no cattle.